Finance Chapter 4 The financial environment: markets, institutions, & interest rates.
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Transcript of Finance Chapter 4 The financial environment: markets, institutions, & interest rates.
FinanceChapter 4The financial environment: markets, institutions, & interest rates
Financial environment
Financial environment Financial markets Financial institutions Tax & regulatory policies State of the economy
Types of financial markets
Physical asset vs. financial asset markets E.g., wheat vs. bonds
Spot markets – “on-the-spot” delivery Futures markets – agreement to buy/sell an
asset at some future date Money markets – loan/borrow funds < 1 year Capital markets – loan/borrow funds > 1 year Primary markets – selling new securities Secondary markets – securities trading by
investors after issuance by corporations
Types of financial markets
Initial public offering (IPO) market – where firms “go public” by offering shares to the public
Private markets – transaction between 2 parties
Public markets – standardized contracts are traded on organized exchanges
Major market instruments See Table 4-1, pages 120-121
U.S. Treasury bills U.S. Treasury notes & bonds Money market funds Consumer credit loans Mortgages Corporate bonds Leases Preferred stocks Common stocks
Derivatives
Any financial asset (contract) whose value is derived from the value of some other underlying asset
Uses: Speculate (anticipating an increased return) Hedge (reduce risk)
Transfers of capital
Direct transfers Transfers through investment banking houses Transfers through financial intermediaries
which create new securities Stock markets
Physical location (NYSE) Electronic (NASDAQ and over-the-counter
market) Capital is allocated through a price system
Lenders receive “rent” (interest) Investors receive dividends & capital gains
Cost of money
Fundamental factors affecting the cost of money:
1. Production opportunities – returns from investments in cash-generating assets
2. Time preferences for consumption – preference of consumers for current vs. future consumption (savings)
3. Risk of low or negative return4. Inflation – the amount prices increase over
time
Cost of money
Risk-free rate of interest, kRF
The real risk-free rate, k*, plus an inflation premium, IP kRF = k* + IP
The nominal (quoted) interest rate also includes default risk (DRP), liquidity (LP), & maturity risk (MRP) kRF = k* + IP + DRP + LP + MRP
Effecting the cost of money: The real rate and inflation change over time Central bank money supply management International currency flows
Cost of money
Effecting the cost of money: The real rate and inflation change over time Central bank money supply management &
International currency flows also lead to interest rate changes
Because interest rate levels are difficult to predict, sound financial policy calls for using a mix of short- and long-term debt